RED SEA UNIVERSITY

MONEY AND BANKING NOTE

Lecturer: Muktar Abdinasir Osman

Course Outline:

Chapter One: Overview of Money and Economics

Chapter Two: Overview of The Financial System

Chapter Three: The Central Bank

Chapter Four: Interest Rates and Rate of Returns

Chapter Five: Security Valuation

Chapter Six: International Banks

Chapter Seven: Monetary Policy and Money Supply

Chapter Eight: The Foreign Exchange Market

Chapter Nine: Financial System Regulations

 CHAPTER ONE: OVERVIEW OF MONEY AND ECONOMICS

Introduction
The definition of Money:
Money is anything that is generally acceptable in exchange for goods and services, without
medium of exchange. Money is the set of assets in the economy that people regularly use to buy
goods and services from other people.
Functions of Money:
There are four functions of Money:
1) Medium of Exchange:
The most important job of money is to serve as a medium of exchange; when any good or service
is purchased, people use money. Money makes it easier to buy and sell because money is
universally accepted. Any commodity or asset that serves as a generally acceptable medium of
exchange is money. Money guarantees that there will always be a double coincidence of wants. If
you have something you wish to exchange, you must find someone who not only wants what you
have to offer but, at some time, also has a supply of the goods you want to obtain. The use of
money as a medium of exchange removes the difficulties of barter, it enables sellers to exchange
goods and services for money and then use the money to obtain whatever goods and services they
desire.
2) Standard of Value
Even under a barter system, exchange can only take place when there is some agreement on what
one thing is worth in terms of another. When all goods and services have money prices, it is easy
to measure the value of one thing in term of another. If the price of Goods X is 1$ and the price of
Goods Y is 3$, then we know that one unit of Y is worth three units of X.
3) Store of Value
People may not wish to spend all their income as soon as they earn it. They may wish to save some
for future consumption. In society which does not use money, this may be very difficult. It would
mean that a farmer would have to store some of the harvest. These things would then have to be
exchanged for whatever was wanted at some future data. In any case, people who produce services,
for example doctors and lawyers cannot store what they produce. Money solves these problems,

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 because we can sell our services or the things we have produced and save the money for spending
in the future. Money, however, is not such a good store of value when prices are rising, because
its value will be falling.
4) A standard for deferred payments:
Just as it would be difficult to carry on trade in goods and services without money, so borrowing
and lending would be difficult to organize without money. If money did not exist, borrowers would
have to find people willing and able to lend the actual goods they required. The debt would have
to repay with similar goods. Now people borrow money and this can be used to buy whatever
goods and services they require. Money, therefore, is a very suitable way of measuring debt 3 and
repaying debt.
The Five Parts of the Financial System:
The financial system has five parts, each of which plays a fundamental role in our economy. These
parts are:
➢ Money: we use the first part of the system, money, to pay for our purchases and to store our
wealth.
➢ Financial Instruments (or securities): it uses to transfer resources from savers to investors and
to transfer risk to those who are best equipped to bear it. They have evolved just as much as
currency. In the last few centuries, investors could buy individual stocks through stockbrokers, but
the transactions were costly.
➢ Financial Markets: the markets were stocks and bonds are sold have undergone a similar
transformation. Originally, financial markets were located in coffeehouses and taverns where
individuals met to exchange financial instruments. ➢ Financial Institutions: the fourth part of the
financial system, provide a myriad of services, including access to the financial markets and
collection of information about prospective borrowers to ensure they are creditworthy, Banks,
securities firms and insurance companies are examples of financial institutions.
➢ Finally, Central Bank: the fifth part of the system, monitor and stabilize the economy. The
Federal Reserve Systemize central bank of the United States.
Needs for Money:
If an economy did not use money, what would it look like? Without money, the buyers would

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exchange goods with the sellers by exchanging one good for another good, which we call barter.
Barter is an act of trading goods or services between two or more parties without the use of money
—or a monetary medium, such as a credit card.
Bartering is the exchange of goods and services between two or more parties without the use of
money. The development of money was necessitated by specialization and exchange. Money was
needed to overcome the shortcomings and frustrations of the barter 4 system which is system where
goods and services are exchange for other goods and services which is called Barter.
Barter is the direct exchange of goods for goods. For example, if you want to pay a hamburger,
you would offer the used paperback novel that you have just finished reading.
Disadvantages or problem of Barter:

1) Double coincidence: Barter suffers from a double coincidence of wants. For example, if you
produce shoes and want to drink a Coca-Cola, then you search for a person who produces Cola-Cola
and needs shoes. Thus, you need to search for a person who wants the opposite of you, which could take a long
time. It is impossible to barter unless A has what B wants, and A has what B has. This is called double
coincidence of wants and is difficult to fulfill in practice. Because of the time and effort spent searching for
trading partners in a barter economy, the transactions costs, or the costs in time or other resources of making
a trade or exchange, will be high
2) Valuation problem: Even when each part what the other has, it does not follow they can agree
on a fair exchange. A good deal of time can be wasted sorting out equations of value.
3) Indivisibility: The indivisibility of large items is another problem. For instance, if a cow is
worth two sacks of wheat, what is one sack of wheat worth? Once again, we may need to carry
over part of the transaction to a large period of time.

4) Perishable nature of other goods: When exchange takes place over time in an economy, it is
necessary to share goods for future exchange. If such goods are perishable by nature, then the
system will breakdown. Many goods, like fruits and vegetables, deteriorate and rot over time.
Growers of perishable goods could not store their purchasing power. They would need to exchange
their products for goods that would not perish quickly if they want to save.
5) Lack of common medium of exchange: The development of industrial economics usually
depends on a division of labor, specialization and allocation of resources on the basis of choices

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and preferences. Economic efficiency is achieved by economizing on the use of the scarcest
resources. Without a common medium of exchange and a common unit of account which is
acceptable to both consumers and producers, it is very difficult to achieve an efficient allocation
of resources to satisfy consumer preference. For these reasons the barter system is discarded by
societies which develop beyond autarky to more specialized methods of production. For such
people a money system is essential.
Importance of bartering
• Bartering can have a psychological benefit because it can create a deeper personal
relationship between trading partners
• Improve sills of individuals

Historical and Evaluation of Money:

Almost any item, any asset, any "thing" can function as money so long as it is generally accepted
as payment. In fact, a lot of different "things" have been used as money over the centuries such as
✓ Gold and Silver,
✓ Copper, Nickel And Animal.
While a number of "things" have been used as money, some have worked better than others. Those
"things" that did not work so well were replaced by other "things" that worked better. Barter: at
the beginning there was no money. People engaged in barter, the exchange of goods for goods,
without value equivalence. Then, the person catching more fish than the necessary for himself and
his group exchanged his excess fish for the surplus of another person who, for instance, had planted
and harvested more

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History of money
What is money? When was money invented? Who invented money? The history of money is
fascinating and goes back thousands of years. From the early days of bartering to the first metal
coins and eventually the first paper money, money has always had an important impact on the way
we function as a society. Money often has no intrinsic value. Instead, money is an object that has
a value placed on it, which allows for the trade of goods and services. Some money, such as metal
coins, has actual value in terms of the materials used. The first metal money dates back to 1000
B.C. China. These coins were made from stamped pieces of valuable metal, such as bronze and
copper. Over time, these coins would evolve to be made from the silver and gold we associate with
money today. Coins were a huge milestone in the history of money because they were one of the
first currencies that allowed people to pay by count (number of coins) rather than weight.

Early coins

Advanced coins

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First Paper Money
While the first paper money was created in China in 700 to 800 A.D., it would be a long time
before paper currency was commonly used and the first country to use paper money was China,
but it was only used until about 1455. The lighter weight of paper money allowed for international
trade, which created both problems—distrust and currency wars—and opportunities—the ability
to trade in new places for new goods.
After China stopped using its paper money during the mid-15th century, coins once again became
the most popular form of money in the country and in the world.

The first banks were started by the Roman Empire around 1800 B.C. These banks offered loans
and accepted deposits from individuals, but would later disappear with the collapse of the empire.
The first bank in the U.S., The Bank of the United States, was established in 1791. The Gold
Standard
In 1816, gold was made the standard of value in the country of England. What this means is that
each banknote represented a certain amount of gold, so only a limited number of banknotes can be
printed. This gave previously unbacked currency some semblance of value and stability. By 1900,
the United States had followed suit with the Gold Standard Act. While this would lead to the U.S.
establishing the central bank that plays an important role in the economy today, the Gold Standard
ended in the 1930s due to the Depression and the devaluation of gold.

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Characteristics of money:
The six characteristics of money are:
1) Durability: This first characteristic means Durability is critical for money to perform the related
functions of medium of exchange and store of value. People are willing to accept an item in payment
for one good because they are confident that the item can be traded at a later time for some other
good. An item works as a medium of exchange precisely because it stores value from one transaction
to the next. And this requires durability. While physical durability has been historically important for
money, social and institutional durability is also important for modern economies. The durability of
modern money, especially paper currency and bank account balances, depends on the durability of
social institutions especially banks and governments. While government- issued paper currency might
remain physically intact for centuries, its ability to function as money depends on the institutional
durability of the government.

2) Divisibility: This second characteristic means money can be divided into small increments that
can be used in exchange for goods of varying values. For an item to function as THE medium of
exchange, which can be used to purchase a wide range of different goods with a wide range of
different values, then it must be divisible. Divisibility is one reason why metals, such as gold, silver
and copper, have been widely used as money throughout history. it must be able to be divided into
smaller units without any loss in value, so that there will be no problem in making both small and
large as money. For example, U.S. money, both paper currency and bank account balance, comes in
increments of one currency, If U.S. money consisted exclusively of $100 gold coins, and nothing
smaller, people would have problems buying goods such as soft drinks, gasoline. These goods and
millions more, have values that cannot be rounded to the nearest $100.

3) Portability (Transportability): This third characteristic means that money can be easily moved
from one location to another when such movement is needed to complete exchanges. When people
head off to the market to make a purchase or two, then they need to bring along their money. That is,
the money must be transportable. Money that is NOT transportable is not transported, so it is not
used. Once again, transportability has played a key role in the use of metals like gold, silver, copper,

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and nickel as money. Carrying around a satchel of metal coins was never much of a burden. However,
these metals were largely replaced by paper 10 currencies in the 20th century because paper was
lighter and easier to carry. In fact, a $100 bill is just as easy to carry as a $1 bill. This notion has been
taken a step farther with paper checks used to access checking account balances. A check for $1
million is just as easy to transport as a check for$1.
4) Valuable relative to its weight: People can easily carry large amounts of money around
conveniently and use it in transactions.
5) Standardized quality: Same units of money must have the identical size, quality, color, so
people know what they are getting. If a government issued money in different sizes and colors, how
would people determine whether bills are legitimate or counterfeit?
Forms of Money

Money facilitates business transactions, and the payment system becomes the mechanism to settle
transactions. First and oldest payment system is commodity money. Commodity money government
selects one commodity from society to become money, such as gold or silver.
Governments and central banks created the second payment system, fiat money, and it is a 20th
century creation. Most central banks in the world today use fiat money.
A fiat money is a type of currency that is declared legal tender by a government but has no intrinsic or
fixed value and is not backed by any tangible asset, such as gold or silver. If the Fed wants to inject
an additional $1 trillion into the economy, it could do so easily. However, a rapid expansion in the
money supply could be drastic to an economy. For instance, countries with high inflation rates or
hyperinflation have rapidly growing money supplies. Hyperinflation is a country’s inflation rate
becomes extremely high, and prices become meaningless.

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Third payment system, a check, is credit money tied to a person’s checking account. Banks, credit
unions, and other financial institutions offer checking accounts to people and businesses.
Then people use checks as a medium of exchange, allowing them to purchase goods and services

Checks have three benefits.

• First, people and businesses do not carry cash.
• Second, the check provides proof of a business transaction.
• Finally, checks become convenient in large transactions, such as buying a house or car.
Checks create two problems.
• First, the financial institution charges fees for using checks, or
• The check writers abuse their accounts and write fraudulent.
Some businesses and people do not accept checks because they cannot verify if a person has

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sufficient funds in his account.

Checks evolved into the last payment system – electronic funds. The most common form being
debit cards. Debit card is a payment card that deducts money directly from your checking account
electronically. Also called “check cards” or "bank cards," debit cards can be used to buy goods or
services or to get cash from an ATM. Debit card can help you reduce the need to carry cash,
although using these cards can sometimes entail fees .

A debit card improves the payments system’s efficiency and extends the function of checks

Bitcoins

The internet created a new money that exists only in cyberspace. We call this money Bitcoin,
where bit refers to the computer term – a piece of information, either a one or zero. This money
has other names including virtual money or cryptocurrency.

Bitcoin is the name of the best-known cryptocurrency, the one for which blockchain technology, as
we currently know it, was created. A cryptocurrency is a medium of exchange, such as the US dollar,
but is digital.

Drawbacks of bitcoin
• Hackers can break into online wallets and steal the Bitcoins. Since all transactions are
electronic, they can erase history, and people may not recover their stolen Bitcoins..

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 • Price of Bitcoin fluctuates greatly between $80 and $1,000, some investors purchased
Bitcoins, hoping to buy at a low price and sell for a high price.
• Few sellers accept Bitcoins as payment

Bitcoin’s value
Bitcoins provide three benefits.
• First, buyers and sellers do not have to reveal their identities to each other. They can
remain secret.
• Second, people can use Bitcoin to launder or smuggle currency outside a country. A buyer
would purchase Bitcoins in one country and withdraw the Bitcoins in another country,
circumventing currency controls.
• Finally, buyers and sellers use Bitcoins to settle transactions in the underground economy
that is hidden within the internet

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 CHAPTER TWO: OVERVIEW OF THE FINANCIAL SYSTEM

INTRODUUCTION
This chapter explains how financial markets link the savers to the borrowers. Savers can use two
separate channels to lend to borrowers. First, the savers could deposit their funds into a financial
institution that in turn, lends to the borrowers. Second, savers could lend directly to the borrowers
by directly investing in financial securities
Financial system transfers funds from savers to borrowers. Savers and borrowers can be anyone.

Some savers
• Households,
• Businesses, And
• Governments
Because they spend less than their income, and they become the source of loans while other are borrowers.
Some borrowers

• households,
• businesses, and
• Governments.
They spend more than their incomes

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Why financial system is important for economy
Funds are transferred from people who have an excess of available funds to people who have a
shortage funds are transferred from people who have an excess of available funds to people who
have a shortage.

Who performs these fund transfers?

Financial institutions and financial markets

Money and the financial system are intertwined and cannot be separated. They both influence and
affect the whole economy. A firm or an individual can obtain funds in a financial market in two ways.
The most common method is to issue a debt instrument, such as a bond or a mortgage. A debt
instrument is short- term if its maturity is less than a year and long-term if its maturity is 10 years
or longer. Debt instruments with a maturity between one and 10 years are said to be intermediate-
term. The

second method of raising funds is by issuing equities, such as common stock, which are claims to
share in the net income (income after expenses and taxes) and the assets of a business

Function of Financial Markets

Financial markets perform the essential economic function of channeling funds from households,
firms, and governments that have saved surplus funds by spending less than their income to those
that have a shortage of funds because they wish to spend more than their income
The arrows show that funds flow from lender-savers to borrower-spenders via two routes. In direct
finance, borrowers borrow funds directly from lenders in financial markets by selling them securities
(also called financial instruments), which are claims on the borrower’s future income or assets
A financial market brings buyers and sellers face to face to buy and sell bonds, stocks, and other
financial instruments. Buyers of financial securities invest their savings, while sellers of financial
securities borrow funds.
Financial institution links the savers and borrowers with the most common being commercial
banks. For example, if you deposited $100 into your savings account, subsequently, the bank could
lend this $100 to a borrower. Then the borrower pays interest to the bank. In turn, the bank would

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pay interest to you for using your funds. Bank’s profits reflect the difference between the interest
rate charged to the borrower and the interest rate the bank pays to you for your savings account.
Why would someone deposit money at a bank instead of directly buying securities through the
financial markets?
A bank, being a financial institution, provides three benefits to the depositor.

• First, a bank collects information about borrowers and lends to borrowers with a low
chance of defaulting on their loans
• Second, the bank reduces your investment risk. Bank lends to a variety of borrowers, such
as home mortgages, business loans, and credit cards.
• Finally, a bank deposit has liquidity. If people have an emergency and need money from
their bank deposits, they can easily convert the bank deposit into cash quickly.
Economists use liquidity to define money. Liquidity is people can easily convert an asset into cash

with little transaction costs. Cash is the most liquid asset because a person already has money and
does not need to convert it to money. Subsequently, a savings account is almost as good as cash
because customers can arrive at a bank or ATM and convert their deposits into cash quickly with
little transaction costs.
Types of financial markets

A primary market is a financial market in which new issues of a security, such as a bond or a
stock, are sold to initial buyers by the corporation or government agency borrowing the funds. A
secondary market is a financial market in which securities that have been previously issued can
be resold

Function of Financial Intermediaries: Indirect Finance

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Funds also can move from lenders to borrowers by a second route called indirect finance because
it involves a financial intermediary that stands between the lender-savers and the borrower-
spenders and helps transfer funds from one to the other.
The process of indirect finance using financial intermediaries, called financial intermediation, is
the primary route for moving funds from lenders to borrowers.
Asymmetric Information: Adverse Selection and Moral Hazard
An additional reason is that in financial markets, one party often does not know enough about the
other party to make accurate decisions. This inequality is called asymmetric information
Adverse selection
Adverse selection is the problem created by asymmetric information before the transaction occurs.
Adverse selection in financial markets occurs when the potential borrowers who are the most likely
to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most
actively seek out a loan and are thus most likely to be selected
Moral hazard

Moral hazard is the problem created by asymmetric information after the transaction occurs.
Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities
that are undesirable (immoral) from the lender’s point of view, because they make it less likely
that the loan will be paid back.
Another way of describing the moral hazard problem is that it leads to conflicts of interest, in
which one party in a financial contract has incentives to act in its own interest rather than in the
interests of the other party
Types of Financial Intermediaries
They fall into three categories: depository institutions (banks), contractual savings institutions, and
investment intermediaries

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Depository Institutions
Depository institutions are financial intermediaries that accept deposits from individuals and
institutions and make loans

Commercial Banks

Commercial bank is a financial institution that provides services like loans, certificates of deposits,
savings bank accounts bank overdrafts, etc. These financial intermediaries raise funds primarily by
issuing checkable deposits (deposits on which checks can be written), savings deposits (deposits that
are payable on demand but do not allow their owner to write checks), and time deposits (deposits
with fixed terms to maturity)

Savings and Loan Associations (S&Ls) and Mutual Savings Banks

These depository institutions, of which there are approximately 1,300, obtain funds primarily
through savings deposits (often called shares) and time and checkable deposits.
Credit Unions
These financial institutions, numbering about 9,500, are typically very small cooperative lending
institutions organized around a particular group: union members, employees of a particular firm, and

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so forth. They acquire funds from deposits called shares and primarily make consumer loans.

Contractual Savings Institutions

Contractual savings institutions, such as insurance companies and pension funds, are financial
intermediaries that acquire funds at periodic intervals on a contractual basis.

Life Insurance Companies

Life insurance companies insure people against financial hazards following a death and sell
annuities (annual income payments upon retirement). They acquire funds from the premiums that
people pay to keep their policies in force and use them mainly to buy corporate bonds and
mortgages.

Fire and Casualty Insurance Companies

These companies insure their policyholders against loss from theft, fire, and accidents. They are
very much like life insurance companies, receiving funds through premiums for their policies, but
they have a greater possibility of loss of funds if major disasters occur. For this reason, they use
their funds to buy more liquid assets than life insurance companies do.

Pension Funds and Government Retirement

Funds Private pension funds and state and local retirement funds provide retirement income in the
form of annuities to employees who are covered by a pension plan. Funds are acquired by
contributions from employers and from employees, who either have a contribution automatically
deducted from their paychecks or contribute voluntarily. The largest asset holdings of pension
funds are corporate bonds and stocks

Investment Intermediaries

This category of financial intermediaries includes finance companies, mutual funds, and money
market mutual funds
Finance Companies
Finance companies raise funds by selling commercial paper (a short-term debt instrument) and by
issuing stocks and bonds. They lend these funds to consumers (who make purchases of such items
as furniture, automobiles and home improvements) and to small businesses.

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Mutual Funds
These financial intermediaries acquire funds by selling shares to many individuals and use the
proceeds to purchase diversified portfolios of stocks and bonds. Mutual funds allow shareholders
to pool their resources so that they can take advantage of lower transaction costs when buying
large blocks of stocks or bonds.

Investment Banks

Despite its name, an investment bank is not a bank or a financial intermediary in the ordinary
sense; that is, it does not take in deposits and then lend them out. Instead, an investment bank is a
different type of intermediary that helps a corporation issue security.

Ensuring the Soundness of Financial Intermediaries

Asymmetric information can lead to the widespread collapse of financial intermediaries, referred
to as a financial panic. A Financial Panic is a sudden, drastic, widespread economic collapse.
All at once, many people become convinced their money or investments are at risk and rush to the
institutions holding their assets. If banks are Unable to pay back all their customers at once, the

institutions go bankrupt, starting a domino effect that brings down the whole economy.

Because providers of funds to financial intermediaries may not be able to assess whether the
institutions holding their funds are sound, if they have doubts about the overall health of financial
intermediaries, they may want to pull their funds out of both sound and unsound institutions. The
possible outcome is a financial panic that produces large losses for the public and causes serious
damage to the economy. To protect the public and the economy from financial panics.

The government has implemented six types of regulations

✓ Restrictions on Entry
✓ Disclosure There are stringent reporting requirements for financial intermediaries.
✓ Restrictions on Assets and Activities There are restrictions on what financial
intermediaries are allowed to do and what assets they can hold
✓ Deposit Insurance The government can insure people’s deposits so that they do not suffer
great financial loss if the financial intermediary that holds these deposits should fail. The

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 Federal Deposit Insurance Corporation (FDIC), which insures each depositor at a
commercial bank, savings and loan association, or mutual savings bank up to a loss of
$250,000 per account
✓ Limits on Competition Politicians have often declared that unbridled competition among
financial intermediaries promotes failures that will harm the public
✓ Restrictions on Interest Rates Competition has also been inhibited by regulations that
impose restrictions on interest rates that can be paid on deposits
If a bank receives a charter from the federal government, then three government agencies can
regulate that bank, which are
• Comptroller of the Currency
• Federal Deposit Insurance Corporation
• Federal Reserve System (Fed)

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 CHAPTER THREE: THE CENTRAL BANK

Definition of Central Bank:

Central bank is a public authority a country’s charged with regulating and controlling a country’s
monetary and financial institutions and markets. The meaning of central bank is a financial
institution that has the privilege of producing and distributing money (and credit) for a country or a
group of countries. A central bank is deemed as the lender of the last resort, as per Hawtrey (a
British economist) This step is taken in times of stress so that the financial structure of the country
is saved from collapsing
Functions of Central Bank:
The central bank generally performs the following functions:
1. Bank of Note Issue: The central bank has the sole monopoly of note issue in almost every country.
The currency notes printed and issued by the central bank become unlimited legal tender throughout
the country. The main advantages of giving the monopoly right of note issue to the central bank are
given below: It brings uniformity in the monetary system of note issue and note circulation. The
central bank can exercise better control over the money supply in the country. It increases public
confidence in the monetary system of the country. Monetary management of the paper currency
becomes easier. Being the best bank of the country, the central bank has full information about the
monetary requirements of the economy and, therefore, can change the quantity of currency
accordingly. It enables the central bank to exercise control over the creation of credit by the
commercial banks. The central bank also earns profit from the issue of paper currency. 2. Banker,
Agent and Adviser to the Government: The central bank functions as a banker, agent and financial
adviser to the government; As a banker to government, the central bank performs the same functions
for the government as a commercial bank performs for its customers. It maintains the accounts of the
central as well as state government; it receives deposits from government; it makes short-term
advances to the government; it provides foreign exchange resources to the government for repaying
external debt or purchasing foreign goods or making other payments. As an Agent to the government,
the central bank collects taxes and other payments on behalf of the government. It raises loans from
the public and thus manages public debt. It also represents the government in the international

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financial institutions and conferences. As a financial adviser to the lent, the central bank gives advice
to the government on economic, monetary, financial and fiscal, deficit financing, trade policy, foreign
exchange policy, etc.
3. Bankers' Bank:
The central bank acts as the bankers' bank in three capacities:
1) As keeper of the cash preserves of the commercial banks;
As a custodian of the cash reserves of the commercial banks the central bank maintains the cash
reserves of the commercial banks. Every commercial bank has to keep a certain percentage of its cash
balances as deposits with the central banks. These cash reserves can be utilized by the commercial
banks in times of emergency. The centralization of cash reserves in the central bank has the following
advantages:
❖ Centralized cash reserves inspire confidence of the public in the banking system of the country.

❖ Centralized cash reserves provide the basis of a larger and more elastic credit structure than if these
amounts were scattered among the individual banks.
❖ Centralized reserves enable the central bank to provide financial accommodation to the commercial
banks which are in temporary difficulties. In fact, the central bank functions as the lender of the last
resort on the basis of the centralized cash reserves.
❖ The system of centralized cash reserves enables the central bank to influence the creation of credit
by the commercial banks by increasing or decreasing the cash reserves through the technique of
variable cash- reserve ratio.
❖ The cash reserves with the central bank can be used to promote national welfare.
2) Lender of Last Resort:
As the highest bank of the country and the bankers' bank, the central bank acts as the lender of the
last resort. In other words, in case the commercial banks are not able to meet their financial
requirements from other sources, they can, as a last resort, approach the central bank for financial
accommodation. The central bank provides financial accommodation to the commercial banks by
rediscounting their eligible securities and exchange bills. The main advantages of the central bank's
functioning as the lender of the last resort are: It increases the elasticity and liquidity of the whole

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credit structure of the economy. It enables the commercial banks to carry on their activities even with
their limited cash reserves. 98 It provides financial help to the commercial banks in times of
emergency. It enables the central bank to exercise its control over banking system of the country.

3) Clearing Agent:
As the custodian of the cash reserves of the commercial banks, the central bank acts as the clearing
house for these banks. Since all banks have their accounts with the central bank, the central bank can
easily settle the claims of various banks against each other with least use of cash. The clearing house
function of the central bank has the following advantages: It economies the use of cash by banks
while settling their claims and counterclaims. It reduces the withdrawals of cash and these enable the
commercial banks to create credit on a largescale. It keeps the central bank fully informed about the
liquidity position of the commercial banks. 4. implementing monetary policies: Central banks
implement a country's chosen monetary policy. A central bank may use another country's currency
either directly (in a currency union), or indirectly (a currency board). In the latter case, exemplified
by Bulgaria, Hong Kong and Latvia, the local currency is backed at a fixed rate by the central bank's
holdings of a foreign currency.
Goals of monetary policy

a) High employment:
Frictional unemployment is the time period between jobs when a worker is searching for, or
transitioning from one job to another. Unemployment beyond frictional unemployment is classified
as unintended unemployment. For example, structural unemployment is a form of unemployment
resulting from a mismatch between demand in the labor market and the skills and locations of the
workers seeking employment. Macroeconomic policy generally aims to reduce unintended
unemployment.

b) Price stability:
Inflation is defined either as the devaluation of a currency or equivalently the rise of prices relative
to currency. Since inflation lowers real wages, Keynesians view inflation as the solution to
involuntary unemployment. However, "unanticipated" inflation leads to lender losses as the real

23
interest rate will be lower than expected. Thus, Keynesian monetary policy aims for a steady rate of
inflation.

c) Economic growth:
Economic growth can be enhanced by investment in capital, such as more or better machinery. A low
interest rate implies that firms can loan money to invest in their capital stock and pay less interest for
it. Lowering the interest is therefore considered to encourage economic growth and is often used to
alleviate times of low economic growth. On the other hand, raising the interest rate is often used in
times of high economic 100 growth as a contra-cyclical device to keep the economy from overheating
and avoid market bubbles. Other goals of implementing monetary policy includes: Interest rate
stability, financial market stability and foreign exchange market stability
Federal reserve bank and European central bank
We explain the structure of the world’s two largest and most powerful central banks in this chapter:
The Federal Reserve System (Fed) and the European Central Bank (ECB). The Fed has an unusual
structure because Congress and the President decentralized the power of its central bank, where each
central bank branch can tailor services for its unique region of the United State. Moreover, the Board
of Governors manages the Fed, while the Federal Open Market Committee handles the purchase
and sale of the U.S. government securities and other assets. Keeping it straight, the Board of
Governors devises monetary policy, while the Open Market Committee puts monetary policy into
action. Then we shift focus to the structure of the European Central Bank, whose structure mirrors
the United States. The Executive Board devises monetary policy while the Governing Council
implements it. Finally, a central bank should remain independent of its government because a self-
governing central bank can focus on price stability and low inflation.
Why the U.S. Government Created Federal Reserve System

The United States was a late comer to the world when it created its central bank. The U.S.
government permanently established a central bank in 1913 and named it the Federal Reserve
System. Congress, government officials, and the public did not want to create a powerful financial
institution, so the U.S. government created the Federal Reserve System to have many checks and
balances. Federal Reserve banks, the Board of Governors of the Federal Reserve System, the

24
Federal Open Market Committee (FOMC), the Federal Advisory Council, and around 2,800-
member commercial banks.

The 12 Federal Reserve banks perform the following functions:

• Clear checks
• Issue new currency
• Withdraw damaged currency from circulation
• Administer and make discount loans to banks in their districts

25
• Evaluate proposed mergers and applications for banks to expand their activities
• Examine bank holding companies and state-chartered member banks
• Collect data on local business conditions
• Use their staffs of professional economists to research topics related to the conduct of monetary
policy
The 12 Federal Reserve banks are involved in monetary policy in several ways:
1. Their directors “establish” the discount rate (although the discount rate in each district is
reviewed and determined by the Board of Governors).
2. They decide which banks, member and nonmember alike, can obtain discount loans from the
Federal Reserve Bank.
3. Their directors select one commercial banker from each bank’s district to serve on the Federal
Advisory Council, which consults with the Board of Governors and provides information that
helps in the conduct of monetary policy.
4. Five of the 12 bank presidents each have a vote on the Federal Open Market Committee, which
directs open market operations
The Board of Governors is actively involved in decisions concerning the conduct of monetary
policy. All seven governors are members of the FOMC and vote on the conduct of open market
operations. Because there are only 12 voting members on this committee (seven governors and
five presidents of the district banks), the Board has the majority of the votes
Board of Governors is the entity that controls the Federal Reserve System. It determines monetary
policy, reserve requirements, and discount policy. Board consists of seven members, who serve a
14-year term. Most board members will not finish their term because they resign and work for the
financial firms on Wall Street for five times their Fed salary. Most European countries formed
their central banks in the 17, 18, and 19th centuries. They converted a large private bank into a
central bank. For example, Great Britain established the Bank of England in 1694, and France
founded the Bank of France in 1800.
The Federal Reserve System comprises of 12 Federal Reserve banks. The United States is
decomposed into 12 regions,
How Independent Is the Fed?

26
 Stanley Fischer, who was a professor at MIT and is now Governor of the Bank of Israel, has
defined two different types of independence of central banks: instrument independence, the
ability of the central bank to set monetary policy instruments, and goal independence, the ability
of the central bank to set the goals of monetary policy

European Central Bank (ECB)

Seventeen EU members use the common currency, the euro that we refer to as the Eurozone. The
Eurozone replicates the United States by forming the world's largest market with a single currency.
The European Central Bank (ECB) manages the euro and is located in Frankfurt, Germany. ECB
was modeled after the Bundesbank, which was Germany’s central bank. Primary goal of the ECB
is to achieve price stability, keeping the euro stable with a low inflation rate. The Governing
Council decides and formulates monetary policy for the European Central Bank and is similar to
the Board of Governors of the Federal Reserve System. The council is composed of the Executive
Board and 17 Governors. The Governors are the heads from their country’s central bank that are
members of the Eurozone. The Executive Board implements monetary policy and manages the
day-to-day operation of the ECB, similar to the Federal Open Market Committee (FOMC). Board
has a president, vice president, and four additional members, whom the European Council selects.
The European Council consists of heads of state of the EU member countries. The European
Council appoints members to the Executive Board for an eight-year term

As a large number of countries shares one currency, it creates four benefits

• First, a single currency has no exchange rate risk. Citizens from different countries can sell
and buy goods with one another, and they do not worry about changes in the exchange rate.
• Second, a single currency reduces the transaction costs because the parties do not convert
one currency
• Third, a single currency helps align political interests. The Eurozone members work and
cooperate with each other as they strive for peace and stability.
• Finally, a single currency promotes competition and regions within the Eurozone begin to
specialize
The European Central Bank (ECB) manages the euro and is located in Frankfurt, Germany. ECB

27
was modeled after the Bundesbank, which was Germany’s central bank. Primary goal of the ECB is
to achieve price stability, keeping the euro stable with a low inflation rate. The Governing

28
Council decides and formulates monetary policy for the European Central Bank and is similar to
the Board of Governors of the Federal Reserve System. The council is composed of the Executive
Board and 17 Governors. The Governors are the heads from their country’s central bank that are
members of the Eurozone.

History of Somali central bank

The Central Bank of Somalia was established in 1968 as the country’s financial regulatory
institution. After years of insecurity, fragility, and economic decline due to the collapse of the state in
1991, The Central Bank was revived and strengthened with the CBS Act of 2011. The Act laid a
new foundation to regulate and boost the country’s finance sector and facilitate economic growth.
The Central Bank of Somalia is led by Governor Abdurrahman Mohamed Abdullahi, who’s
also the chairman of the bank’s board of directors. The governor’s office is comprised of the
following sections. The Office of the Governor’s primary function is to support the governor to
execute on his mandate to lead CBS in fostering price stability and building a robust, stable and up-
to-date financial sector. The central bank of Somalia is led by seven highly qualified governors.

29
 CHAPTER FOUR: INTEREST RATES AND RATE OF RETURNS
Tim Value of money
What Is the Time Value of Money (TVM)?
The time value of money (TVM) is the concept that a sum of money is worth more now than the
same sum will be at a future date due to its earnings potential in the interim. The time value of money
is a core principle of finance. A sum of money in the hand has greater value than the same sum to be
paid in the future. The time value of money is also referred to as the present discounted value.
• Investors prefer to receive money today rather than the same amount of money in the future
because a sum of money, once invested, grows over time. For example, money deposited
into a savings account earns interest. Over time, the interest is added to the principal,
earning more interest.
Today, economists consider the interest rate to be the cost of credit.
Why Do Lenders Charge Interest on Loans?
If apple growers charged a zero price for apples, very few apples would be supplied. Similarly, if
lenders, who are suppliers of credit, didn’t charge interest on loans, there would be very little credit
supplied. Recall from your introductory economics course the important idea of opportunity cost,
which is the value of what you have to give up to engage in an activity. Just as the price of apples
has to cover the opportunity cost of supplying apples, the interest rate has to cover the opportunity
cost of supplying credit.
Consider the following situation: You make a $1,000 loan to a friend who promises to pay back the
money in one year. There are three key facts you need to take into account when deciding how much
interest to charge him:
(1) By the time your friend pays you back, prices are likely to have risen, so you will be able to buy
fewer goods and services than you could have if you had spent the money rather than lending it;
(2) your friend might not pay you back; in other words, he might default on the loan; and
(3) during the period of the loan, your friend has use of your money, and you don’t. If he uses the
money to buy a computer, he gets the use of the computer for a year, while you wait for him to pay
you back. In other words, lending your money involves the opportunity cost of not being able to spend it on
goods and services today

30
So, we can think of the interest you charge on the loan as being the result of:
● Compensation for inflation
● Compensation for default risk—the chance that the borrower will not pay back the loan
● Compensation for the opportunity cost of waiting to spend your money

Time value of money is the way that the value of a payment changes depending on when the
payment is received.
Future value is the value at some future time of an investment made today
Compounding is the process of earning interest on interest as savings accumulate over time
Present value the value today of funds that will be received in the future.
Discounting is the process of finding the present value of funds that will be received in the future

The Interest Rate

• Which would you prefer – $1,000 today or $1,000 ten years from today? Common sense
tells us to take the $1,000 today because we recognize that there is a time value to money.
The immediate receipt of $1,000 provides us with the opportunity to put our money to work
and earn interest.
Simple interest is Interest paid (earned) on only the original amount, or principal, borrowed (lent).
The dollar amount of simple interest is a function of three variables: the original amount borrowed
(lent), or principal; the interest rate per time period; and the number of time periods for which the
principal is borrowed (lent). The formula for calculating simple interest is
• SI = P(I)(N) or PRT
Where
• SI = simple interest in dollars
• P = principal, or original amount borrowed (lent) at time period
• i = interest rate per time period
• n = number of time periods

Compounding and Discounting

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Consider an example of compounding. Suppose that you deposit $1,000 in a bank certificate of
deposit (CD) that pays an interest rate of 5%. What will be the future value of this investment? Future
value refers to the value at some future time of an investment made today. In one year, you will
receive back your $1,000 principal—which is the amount invested (or borrowed)—and 5% interest
on your $1,000, or: $1,000 + ($1,000 * 0.05) = $1,050.

For example, assume that you deposit $100 in a savings account paying 8 percent simple interest
and keep it there for 10 years. At the end of 10 years, the amount of interest accumulated is
determined as follows:
• $80 = $100(0.08) (100)
Compound interest is Interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent). The distinction between simple and compound interest can best be seen
table below.

Present value and future value

• Future value (terminal value) the value at some future time of a present amount of money,
or a series of payments, evaluated at a given interest rate. The formula to calculate future
value of money is
• FVn = P0[1 + (i)(n)]
To solve for the future value (also known as the terminal value) of the account at the end of 10
years (FV10), we add the interest earned on the principal only to the original amount invested.
Therefore

32
FV10 = $100 + [$100(0.08) (10)] = $180

Present value is the current value of a future amount of money, or a series of payments, evaluated
at a given interest rate.
• PV = FVn /[1 + (i)(n)]
• The formula can also be rearranged to find the value of the future sum in present-day
dollars. For example, the present-day dollar amount compounded annually at 7% interest
that would be worth $5,000 one year from today is:
• PV=[(5,000/1+17%) $ =$4,673

Return is the total earnings from a security; for a bond, the coupon payment plus the change in the
price of the bond.
Rate of return, R is the return on a security as a percentage of the initial price; for a bond, the coupon
payment plus the change in the price of a bond divided by the initial price

Nominal interest rate is an interest rate that is not adjusted for changes in purchasing power.
Real interest rate is an interest rate that is adjusted for changes in purchasing power
The total amount of money due at the end of a loan period—the amount of the loan and the interest—
is called the maturity value of the loan. When the principal and interest of a loan are known, the
maturity value is found by adding the principal and the interest.
MV = P(1 + RT)

33
 Questions

1. . Find the interest paid on a loan of $38,000 for one year at a simple interest rate of 10.5%.

2. Suppose you are considering investing $1,000 in one of the following bank CDs: First the
CD, will pay an interest rate of 4% per year for three years how much will you get after three
years FV?

3. If the Second CD, which will pay an interest rate of 10% the first year, 1% the second year,
and 1% the third year Which CD should you choose?

4. The 7th Inning borrowed $6,700 at 9.5% simple interest for three years. How much interest is paid?

5. How much is paid at the end of two years for a loan of $8,000 if the total interest is $660?

6. Find the maturity value of a $1,800 loan made for two years at simple interest per year.

7. A loan of $7,250 is to be repaid in three years and has a simple interest rate of 12%. How much is
paid after the three years?

8. Find the maturity value of a three-year, simple interest loan at 11% per year in the amount of $7,275.

9. What is the simple interest rate of a loan of $2,680 for 2 if $636.50 interest is paid?

10. How much money is borrowed if the interest rate is simple interest and the loan is made for 3.5 years
and has $904.88 interest

11. A loan of $16,840 is borrowed at 9% simple interest and is repaid with $4,167.90 interest. What is
the duration of the loan?

12. Find the simple interest rate of a loan of $5,000 that is made for three years and requires $1,762.50
in interest.

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 CHAPTER FIVE: SECURITY VALUATION
INTRODUCTION

Debt Instruments and Their Prices

Our conclusion at the end of the last section is a key fact about the financial system, so it is worth
restating: The price of a financial asset is equal to the present value of the payments to be received
from owning it. We can apply this key fact to an important class of financial assets called debt
instruments. Debt instruments (also called credit market instruments or fixed-income assets) include
loans granted by banks and bonds issued by corporations and governments. Stocks are not debt
instruments because stocks are equities that represent part ownership in the firms that issue them.
Debt instruments can vary in their terms, but they are all IOUs, or promises by the borrower both to
pay interest and repay principal to the lender. Debt instruments take different forms because lenders
and borrowers have different needs.
Bond is a long-term debt instrument issued by a corporation or government.
Face value is the stated value of an asset. In the case of a bond, the face value is usually $1,000.
Coupon rate is the stated rate of interest on a bond; the annual interest payment divided by the bond’s
face value.
Perpetual Bonds is a bond that never matures
Present Value of Perpetual Bond= V = I /k d
Thus, the present value of a perpetual bond is simply the periodic interest payment divided by the
appropriate discount rate per period. Suppose you could buy a bond that paid $50 a year forever.
Assuming that your required rate of return for this type of bond is 12 percent, the present value of this
security would be V = $50/0.12 = $416.67
This is the maximum amount that you would be willing to pay for this bond. If the market price is
greater than this amount, however, you would not want to buy it
Bonds with a Finite Maturity
Loans, Bonds, and the Timing of Payments
There are four basic categories of debt instruments:
1. Simple loans
2. Discount bonds

35
3. Coupon bonds
4. Fixed-payment loan

Debt instruments (also known as credit market instruments or fixedincome assets) Methods of
financing debt, including simple loans, discount bonds, coupon bonds, and fixed payment loans.

Equity is A claim to part ownership of a firm; common stock issued by a corporation.

Simple loan is A debt instrument in which the borrower receives from the lender an amount called
the principal and agrees to repay the lender the principal plus interest on a specific date when the loan
matures.

Discount bond is A debt instrument in which the borrower repays the amount of the loan in a single
payment at maturity but receives less than the face value of the bond initially.

Coupon bond is A debt instrument that requires multiple payments of interest on a regular basis,
such as semiannually or annually, and a payment of the face value at maturity.

Nonzero Coupon Bonds.

If a bond has a finite maturity, then we must consider not only the interest stream but also the terminal
or maturity value (face value) in valuing the bond
.

Coupon Bond Prices

Consider a five-year coupon bond with a coupon rate of 6% and a face value of $1,000. The coupon
rate of 6% tells us that the seller of the bond will pay the buyer of the bond $60 per year for five years,

36
as well as make a final payment of $1,000 at the end of the fifth year. (Note that, in practice, coupons
are typically paid twice per year, so a 6% bond will pay $30 after six months and another $30 at the
end of the year. For simplicity, we will assume throughout this book that any payments made on

a security is received at the end of the year.) Therefore, the expression for the price, P, of the bond
is the sum of the present values of the six payments the investor will receive:
solution

We can use this reasoning to arrive at a general expression for a bond that makes coupon payments,
C, has a face value, FV, and matures in n years:

What is financial security?

Security is a financial instrument that can be traded between parties in the open market.

What are the Types of Security?

There are four main types of security: debt securities, equity securities, derivative securities, and
hybrid securities, which are a combination of debt and equity.

Debt Securities

Debt securities, or fixed-income securities, represent money that is borrowed and must be repaid
with terms outlining the amount of the borrowed funds, interest rate, and maturity date. In other
words, debt securities are debt instruments, such as bonds (e.g., a government or municipal bond)
or a certificate of deposit (CD) that can be traded between parties.

37
 Debt securities, such as bonds and certificates of deposit, as a rule, require the holder to make the
regular interest payments, as well as repayment of the principal amount alongside any other
stipulated contractual rights. Such securities are usually issued for a fixed term, and, in the end,
the issuer redeems them.

A debt security’s interest rate on a debt security is determined based on a borrower’s credit history,
track record, and solvency – the ability to repay the loan in the future. The higher the risk of the

borrower’s default on the loan, the higher the interest rate a lender would require to compensate for
the amount of risk taken.

Equity Securities

Equity securities represent ownership interest held by shareholders in a company. In other words,
it is an investment in an organization’s equity stock to become a shareholder of the organization.

The difference between holders of equity securities and holders of debt securities is that the former is
not entitled to a regular payment, but they can profit from capital gains by selling the stocks. Another
difference is that equity securities provide ownership rights to the holder so that he becomes one of
the owners of the company, owning a stake proportionate to the number of acquired shares.

In the event a business faces bankruptcy, the equity holders can only share the residual interest
that remains after all obligations have been paid out to debt security holders. Companies regularly
distribute dividends to shareholders sharing the earned profits coming from the core business
operations, whereas it is not the case for the debtholders.

Derivative Securities

Derivative securities are financial instruments whose value depends on basic variables. The
variables can be assets, such as stocks, bonds, currencies, interest rates, market indices, and goods.
The main purpose of using derivatives is to consider and minimize risk. It is achieved by insuring

38
 against price movements, creating favorable conditions for speculations and getting access to hard-
to-reach assets or markets.

Formerly, derivatives were used to ensure balanced exchange rates for goods traded
internationally. International traders needed an accounting system to lock their different national
currencies at a specific exchange rate.

There are four main types of derivative securities:

Futures

Futures, also called futures contracts, are an agreement between two parties for the purchase and
delivery of an asset at an agreed-upon price at a future date. Futures are traded on an exchange,
with the contracts already standardized. In a futures transaction, the parties involved must buy or
sell the underlying asset.

Forwards

Forwards, or forward contracts, are similar to futures, but do not trade on an exchange, only
retailing. When creating a forward contract, the buyer and seller must determine the terms, size,
and settlement process for the derivative.

Another difference from futures is the risk for both sellers and buyers. The risks arise when one
party becomes bankrupt, and the other party may not able to protect its rights and, as a result, loses
the value of its position.

Options

Options, or options contracts, are similar to a futures contract, as it involves the purchase or sale
of an asset between two parties at a predetermined date in the future for a specific price. The key
difference between the two types of contracts is that, with an option, the buyer is not required to
complete the action of buying or selling.

39
Swaps

Swaps involve the exchange of one kind of cash flow with another. For example, an interest rate
swap enables a trader to switch to a variable interest rate loan from a fixed interest rate loan, or
vice versa.

Where n is the number of years until final maturity and MV is the maturity value of the bond. We
might wish to determine the value of a $1,000-par-value bond with a 10 percent coupon and nine
years to maturity. The coupon rate corresponds to interest payments of $100 a year. If our required
rate of return on the bond is 12 percent, then
The interest payments have a present value of $532.80, whereas the principal payment at maturity
has a present value of $360.00
If the appropriate discount rate is 8 percent instead of 12 percent, the valuation equation becomes
Zero-Coupon Bonds
A zero-coupon bond makes no periodic interest payments but instead is sold at a deep discount
from its face value. Why buy a bond that pays no interest? The answer lies in the fact that the buyer
of such a bond does receive a return.

40
We find that the present value interest factor for a single payment 10 periods in the future at 12
percent is 0.322. Therefore: V = $1,000(0.322) = $322
If you could purchase this bond for $322 and redeem it 10 years later for $1,000, your initial
investment would thus provide you with a 12 percent compound annual rate of return.
Preferred Stock Valuation
Preferred stock is A type of stock that promises a (usually) fixed dividend, but at the discretion
of the board of directors. It has preference over common stock in the payment of dividends and
claims on assets.
Preferred stock has no stated maturity date and, given the fixed nature of its payments, is similar
to a perpetual bond. It is not surprising, then, that we use the same general approach as applied to
valuing a perpetual bond to the valuation of preferred stock.4 Thus the present value of preferred
stock is

41
 CHAPTER SIX: INTERNATIONAL BANKS

INTRODUCTION
Globalization influences the financial markets. In the last 40 years, savers and borrowers have
become linked through the international financial markets. For example, a Japanese bank transfers
funds from savers in Japan to lend to a company that builds a new factory in China.
Thus, funds move between countries, and investors have access to financial markets that scale
across the world. Globalization has impacted the financial markets as products, services, and
money flow across a country’s borders.
Moreover, globalization increased rapidly since World War II and has three causes.
• First, many government leaders’ repealed laws that restricted the free flow of investment
between countries.
• Second, countries are growing economically. Thus, the savers can channel their funds into
the international financial markets, pursuing greater returns abroad.
• Finally, international corporations produce products in one country and ship them to
another. Furthermore, corporations need financing to engage in business in foreign
countries; thus, they work with international banks.
An international bank operates in two or more countries. Corporations move products, services,
and resources across international borders while the banks move the money
Functions of International Banks
International banks transcend the functions of a domestic bank because they link savers and
borrowers across different countries. Consequently, an international bank helps people and
businesses engage in international trade and finance. An international bank helps with foreign-
currency exchange rates and holds inventories of foreign currencies.
International banks provide three benefits.
❖ First, international banks accept deposits from savers and lend to borrowers, and the savers
and borrowers are located in different countries
❖ Second, international banks lower transaction costs by reducing information costs,
lowering the risk of investments

42
 ❖ Increasing the liquidity of financial markets. Liquidity is the ease of converting assets to
currency.
International banks are also located in offshore markets. An offshore market has little regulations,
low tax rates, and strict banker-customer confidentiality laws
Becoming an International Bank

Banks in the United States use four methods to become an international bank, which are:
Method 1: The U.S. bank opens a bank branch in a foreign country. These branches accept
deposits and make loans. U.S. banks open branches in financial centers around the world or places
where U.S. firms and corporations engage in business.
Method 2: The U.S. bank becomes a holding company. The U.S. bank buys and becomes a
majority shareholder of a foreign bank. The Federal Reserve System restricts U.S. banks to invest
in foreign firms that are “closely related to banking.”
Method 3: The U.S. bank becomes an Edge Act Corporation. The U.S. bank establishes a
subsidiary. Subsidiary can accept deposits from both U.S. residents and foreigners but can only
grant loans for international business activity.
Method 4: The U.S. bank creates an international banking facility (IBF). An international
banking facility, similar to an Edge Act corporation, accepts deposits from foreigners and makes
loans to foreigners. The IBFs cannot conduct any business within the United States except with its
parent company or with other IBFs.
Foreign banks can enter the banking market in the United States, using three methods.

Method 1: Foreign bank opens an agency office. Agency office cannot accept deposits from U.S.
residents, but it can lend to them. Moreover, the agency office is not subjected to U.S. banking
laws and does not carry FDIC deposit insurance.
Method 2: A foreign bank does business in the U.S. through a foreign bank branch. This is a full
fledge bank that accepts deposits and makes loans. Consequently, the foreign bank branch must
follow the U.S. banking regulations.

43
Method 3: A foreign bank enters the U.S. market through a subsidiary U.S. bank. Foreign bank
buys U.S. bank stock, becoming the majority shareholder. Thus, the foreign bank controls the U.S.
bank, converting it into a subsidiary.
Exchange Rate Risk
An exchange rate equals the ratio of one currency to another currency. We usually write an
exchange rate as Equation 1. For example, one U.S. dollar equals 1.5 euros. $1 = 1.5 euros. For
instance, you plan a trip to the United States, and want to convert 1,500 euros into U.S. dollars.
How many U.S. dollars would you have?
Exchange rates can fluctuate over time. If the exchange rate had changed to $1 = 2 euros,
subsequently, the U.S. dollar buys more euros. Thus, the U.S. dollar appreciated. If the U.S. dollar
appreciated, then the euro automatically depreciated. Consequently, appreciation means a
currency becomes worth more in terms of another currency, while depreciation implies the other
currency falls in value.
Fluctuating exchange rates leads to the exchange rate risk, which can financially harm
international banks, investors, and businessmen. Thus, they must analyze and examine the trends
in exchange rates.
If the exchange rate equals $1 for 25 rubles, we compute the bank’s loan at 25 million rubles
International Financial Securities
International banks created several financial securities to hedge against foreign exchange rate risk.
Moreover, some financial securities allow international banks to circumvent government
regulations and to facilitate international trade.
A bank, business, or investor can use a derivative as the first line of defense against the exchange
rate risk. A derivative is a contract for a future exchange of a commodity for money at a known
price on a particular date.
For example, a buyer and seller agree to a future price of coffee today. The day the contract expires;
the buyer must buy the coffee for the price and quantity specified in the contract. Derivative
contract protects a bank, company, or investor from price fluctuations, and they can buy and sell
the contracts on the secondary markets before the contract matures.

44
A derivative contract has many different forms. First form is a forward contract

45
 CHAPTER SEVEN: MONEYTARY POLICY AND MONEY SUPPLY

INTRODUCTION
Money, loans, and banks are all tied together. Money is deposited in bank accounts, which is then
loaned to businesses, individuals, and other banks. When the interlocking system of money, loans, and
banks works well, economic transactions are made smoothly in goods and labor markets and savers
are connected with borrowers. If the money and banking system does not operate smoothly, the
economy can either fall into recession or suffer prolonged inflation.
The government of every country has public policies that support the system of money, loans, and
banking. But these policies do not always work perfectly. This chapter discusses how monetary policy
works and what may prevent it from working perfectly.

What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the overall money supply
and promote economic growth and employ strategies such as revising interest rates and changing
bank reserve requirements.
What is the difference between monetary policy and fiscal policy, and how are they related?
Monetary policy refers to the actions of central banks to achieve macroeconomic policy objectives
such as price stability, full employment, and stable economic growth.
Fiscal policy refers to the tax and spending policies of the federal government. Fiscal policy decisions
are determined by the Congress and the Administration; the Fed plays no role in determining fiscal
policy.

It generally boils down to adjusting the supply of money in the economy to achieve some combination
of inflation and output stabilization.
Who is responsible monetary policy?
This is why monetary policy—generally conducted by central banks such as the U.S. Federal Reserve
(Fed) or the European Central Bank (ECB)—is a meaningful policy tool for achieving both inflation
and growth objectives.

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What happens when the economy of the country is in recession?
• consumers stop spending as much as they used to;
• business production declines,
• leading firms to lay off workers and stop investing in new capacity;
• And foreign appetite for the country’s exports may also fall.
In short, there is a decline in overall, or aggregate, demand to which government can respond with
a policy that leans against the direction in which the economy is headed.

Monetary policy is not the only tool for managing aggregate demand for goods and services. Fiscal
policy—taxing and spending—is another, and governments have used it extensively during the
recent global crisis.

A central bank may revise the interest rates it charges to loan money to the nation's banks. As rates
rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers.
Monetary base equals the currency in circulation plus reserves held by commercial banks.
Currency in circulation is the Federal Reserve Notes the public is holding.
Banks are required to have reserve
Using a simple example, the central bank sets the required reserve ratio to 10%, which is the
percentage of total reserves that banks must hold as reserves at the Fed or as vault cash. If you
open a bank account by depositing $100, then the bank must hold 10% of your deposit, which
equals $10. Thus, the $10 is the required reserves. A bank could hold more than $10, which are
excess reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary depending on the level of
growth or stagnation within the economy.
Expansionary monetary policy is the Federal Reserve expands the money supply and indirectly
reduces the short-term interest rates while
Contractionary monetary policy is the Federal Reserve contracts the money supply that raises
short-term interest rates.

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Contractionary
A contractionary policy increases interest rates and limits the outstanding money supply to slow
growth and decrease inflation, where the prices of goods and services in an economy rise and
reduce the purchasing power of money.

Expansionary
During times of slowdown or a recession, an expansionary policy grows economic activity. By
lowering interest rates, saving becomes less attractive, and consumer spending and borrowing
increase

Goals of Monetary Policy

Goal of monetary policy is to increase the well-being of society. Economists measure wellbeing
in terms of the quantity and quality of goods and services that people consume.
The central banks have six monetary policy goals, which are:
Price stability: Product prices communicate information to households and businesses.
Households determine how many goods to buy while businesses determine how many goods to
produce
If the inflation rate soars, then money’s functions of a “store of value” and “medium of exchange”
breaks down
High employment: The central banks and the federal government reduce unemployment as much
as possible because massive unemployment causes human misery. Currently, economists
estimate the natural rate of unemployment to be 6% for the United States.
Economic growth: A growing economy has an increasing real GDP because society produces
more goods and services. A high real GDP growth rate lowers the unemployment rate while
businesses earn profits.
Financial market and institution stability: Financial panics, bank runs, stock market crashes, or
bankruptcies of large financial institutions could trigger a chain reaction that causes other financial
institutions to bankrupt

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 Interest rate stability: The Fed stabilizes the interest rates because fluctuating interest rates create
uncertainty in the economy, and businesses, and households experience difficulties planning for
the future.

Foreign-exchange market stability: The Fed tries to stabilize the U.S. dollar’s value against the
major currencies, such as the Japanese yen and European euro. A strong U.S. dollar causes U.S
products to become relatively more expensive to foreigners while foreign-made products become
cheaper to U.S. citizens. Exchange Rates The exchange rates between domestic and foreign
currencies can be affected by monetary policy. With an increase in the money supply, the domestic
currency becomes cheaper than its foreign exchange
The European Central Bank, on the other hand, has only one policy goal – price stability.
The ECB defines price stability as an inflation rate of 2% or less

Tools of Monetary Policy

A central bank has three traditional tools to implement monetary policy in the economy:
• Open market operations
• Changing reserve requirements
• Changing the discount rate
Open Market Operations
The most commonly used tool of monetary policy in the U.S. is open market operations. Open
market operations take place when the central bank sells or buys U.S. Treasury bonds in order to
influence the quantity of bank reserves and the level of interest rates. In open market operations
(OMO), the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors
to change the number of outstanding government securities and money available to the economy
as a whole. The Fed, for example, wants to expand the money supply by using expansionary
monetary policy. Then the Fed buys T-bills, creating a greater demand for T-bills, shifting the
demand function rightward. The Fed pays for the T-bills using a “Fed check.” After the seller
deposits the check at his bank, then his or her bank's reserves increase, boosting the money supply
as banks grant loans to borrowers
Changing Reserve Requirements

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A second method of conducting monetary policy is for the central bank to raise or lower the
reserve requirement, which, as we noted earlier, is the percentage of each bank’s deposits that it
is legally required to hold either as cash in their vault or on deposit with the central bank. Lowering

this reserve requirement releases more capital for the banks to offer loans or buy other assets.
Increasing the requirement curtails bank lending and slows growth
Changing the Discount Rate
The Federal Reserve was founded in the aftermath of the Financial Panic of 1907 when many
banks failed as a result of bank runs. As mentioned earlier, since banks make profits by lending
out their deposits, no bank, even those that are not bankrupt, can withstand a bank run. As a result
of the Panic, the Federal Reserve was founded to be the “lender of last resort.” In the event of a
bank run, sound banks, (banks that were not bankrupt) could borrow as much cash as they needed
from the Fed’s discount “window” to quell the bank run. The interest rate banks pay for such loans
is called the discount rate
Interest Rates
The central bank may change the interest rates or the required collateral that it demands. In the
U.S., this rate is known as the discount rate. Banks will loan more or less freely depending on this
interest rate.

The Fed can grant loans to financial institutions. For example, a bank experiences financial
problems and needs reserves. Consequently, the bank sells a $10,000 T-bill to the Fed, and the Fed
boosts bank’s reserves by $9,000. The discount is the difference while the T-bill becomes the
collateral of the loan. Eventually, the bank repays the Fed loan, and afterwards, the Fed returns the
T-bill for $10,000 to the bank. The $1,000 difference reflects the interest rate the Fed charges for
the loan, called the discount rate.
Time Lags
The Fed cannot influence the monetary policy goals directly. The Fed uses its tools, open market
operations, discount rates, and reserve requirements, to influence indirectly its policy goals.
Unfortunately, three-time lags hinder monetary policy

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 Information lag

The Federal Reserve or government needs data and information before it can do anything, the
information la. For instance, government calculates the unemployment rate monthly and estimates
GDP data quarterly. The government requires nine months to know whether the economy has

entered a recession. Thus, a government knows the economy is in a recession by the end of the
third quarter.
Administrative lag
Second, the Federal Reserve or government must study the data, and then they devise and approve
a policy, the administrative lag.
Impact lag
Finally, a monetary policy does not impact the economy immediately. It takes time when the Fed
implements a policy until it shows up on the economy, the impact lag.

Monetary policy affects the economy only after a time lag that is typically long and of variable
length. Remember, monetary policy involves a chain of events: the central bank must perceive a
situation in the economy, hold a meeting, and make a decision to react by tightening or loosening
monetary policy.
Pitfalls for Monetary Policy
Monetary policy is inevitably imprecise, for a number of reasons:
(a) The effects occur only after long and variable lags;
(b) If banks decide to hold excess reserves, monetary policy cannot force them to lend

What is the money supply? Is it important?

The money supply is the total amount of money—cash, coins, and balances in bank accounts—in
circulation.
The money supply is commonly defined to be a group of safe assets that households and businesses
can use to make payments or to hold as short-term investments. For example,

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 ✓ U.S. currency and

✓ Balances held in checking accounts and

✓ Savings accounts
are included in many measures of the money supply

There are several standard measures of the money supply, including the

✓ Monetary Base,

✓ M1, And

✓ M2.

• The monetary base: the sum of currency in circulation and reserve balances (deposits held
by banks and other depository institutions in their accounts at the Federal Reserve).
• M1: the sum of currency held by the public and transaction deposits at depository institutions
(which are financial institutions that obtain their funds mainly through deposits from the
public, such as commercial banks, savings and loan associations, savings banks, and credit
unions).
• M2: M1 plus savings deposits, small-denomination time deposits (those issued in amounts of
less than $100,000), and retail money market mutual fund shares

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Inflation is an increase in the prices of goods and services. The most well-known indicator of
inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a
basket of goods and services consumed by households

The main causes of inflation can be grouped into three broad categories:

❖ Demand-pull,

❖ Cost-push, and

❖ Inflation expectations.
Demand-pull inflation
Demand-pull inflation arises when the total demand for goods and services (i.e. ‘aggregate demand’)
increases to exceed the supply of goods and services (i.e. ‘aggregate supply’) that can be sustainably
produced. The excess demand puts upward pressure on prices across a broad range of goods and

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services and ultimately leads to an increase in inflation – that is, it ‘pulls’ inflation higher.

Cost-push inflation
Cost-push inflation occurs when the total supply of goods and services in the economy which can
be produced (aggregate supply) falls. A fall in aggregate supply is often caused by an increase in the
cost of production. If aggregate supply falls but aggregate demand remains unchanged, there is
upward pressure on prices and inflation – that is, inflation is ‘pushed’ higher.

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What is Hyperinflation?
In economics, hyperinflation is used to describe situations where the prices of all goods and services
rise uncontrollably over a defined time period. In other words, hyperinflation is extremely
rapid inflation.
Generally, inflation is termed hyperinflation when the rate of inflation grows at more than 50% a
month.
Effects of Hyperinflation
Hyperinflation quickly devalues the local currency in foreign exchange markets as the relative value
in comparison to other currencies drops. This situation, will drive holders of the domestic currency
to minimize their holdings and switch to more stable foreign currencies.

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 CHAPTER EIGHT: THE FOREIGN EXCHANGE MARKET
Introduction
In the mid-1980s, American businesses became less competitive with their foreign counterparts;
subsequently, in the 1990s and 2000s, their competitiveness increased. Did this swing in
competitiveness occur primarily because American management fell down on the job in the 1980s
and then got its act together afterwards? Not really. American business became less competitive
in the 1980s because American dollars became worth more in terms of foreign currencies, making
American goods more expensive relative to foreign goods. By the 1990s and 2000s, the value of
the U.S. dollar had fallen appreciably from its highs in the mid-1980s, making American goods
cheaper and American businesses more competitive. The price of one currency in terms of another
is called the exchange rate.
Foreign Exchange Market
Most countries of the world have their own currencies: The United States has its dollar; the
European Monetary Union, its euro; Brazil, its real; and China, its yuan.
Trade between countries involves the mutual exchange of different currencies
The trading of currencies and bank deposits denominated in particular currencies takes place in
the foreign exchange market. Transactions conducted in the foreign exchange market determine
the rates at which currencies are exchanged.
What Are Foreign Exchange Rates?
There are two kinds of exchange rate transactions. The predominant ones, called spot
transactions, involve the immediate (two-day) exchange of bank deposits. Forward transactions
involve the exchange of bank deposits at some specified future date.
When a currency increases in value, it experiences appreciation; when it falls in value and is
worth fewer U.S. dollars, it undergoes depreciation. At the beginning of 1999, for example, the
euro was valued at $1.18 and, as indicated in the Following the Financial News box, on June 23,
2010, it was valued at $1.23. The euro appreciated by 4%:

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When a country’s currency appreciates (rises in value relative to other currencies), the
country’s goods abroad become more expensive and foreign goods in that country become
cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s
currency depreciates, its goods abroad become cheaper and foreign goods in that country
become more expensive.
Depreciation of a currency makes it easier for domestic manufacturers to sell their goods abroad
and makes foreign goods less competitive in domestic markets. From 2002 to 2010, the
depreciating dollar helped U.S. industries sell more goods, but it hurt American consumers because
foreign goods were more expensive. The prices of French wine and cheese and the cost of
vacationing abroad all rose as a result of the weak dollar.
How Is Foreign Exchange Traded?
You cannot go to a centralized location to watch exchange rates being determined; currencies are
not traded on exchanges such as the New York Stock Exchange. Instead, the foreign exchange

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market is organized as an over-the-counter market in which several hundred dealers (mostly banks)
stand ready to buy and sell deposits denominated in foreign currencies
Exchange Rates in the Long Run
Like the price of any good or asset in a free market, exchange rates are determined by the
interaction of supply and demand
Law of One Price
The starting point for understanding how exchange rates are determined is a simple idea called the
law of one price: If two countries produce an identical good, and transportation costs and trade
barriers are very low, the price of the good should be the same throughout the world no matter
which country produces it. Suppose that American steel costs $100 per ton and identical Japanese
steel costs 10,000 yen per ton. For the law of one price to hold, the exchange rate between the yen
and the dollar must be 100 yen per dollar ($0.01 per yen) so that one ton of American steel sells
for 10,000 yen in Japan (the price of Japanese steel) and one ton of Japanese steel sells for $100
in the United States (the price of U.S. steel)
Theory of Purchasing Power Parity
One of the most prominent theories of how exchange rates are determined is the theory of
purchasing power parity (PPP). It states that exchange rates between any two currencies will
adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an
application of the law of one price to national price levels. if the law of one price holds, a 10% rise
in the yen price of Japanese steel results in a 10% appreciation of the dollar the theory of PPP
suggests that if one country’s price level rises relative to another’s, its currency should
depreciate (the other country’s currency should appreciate).
Factors That Affect Exchange Rates in the Long Run
In the long run, four major factors affect the exchange rate:
✓ relative price levels,
✓ tariffs and quotas,
✓ preferences for domestic versus foreign goods,
✓ and productivity.

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if a factor increases the demand for domestic goods relative to foreign goods, the domestic
currency will appreciate; if a factor decreases the relative demand for domestic goods, the
domestic currency will depreciate

✓ Relative Price Levels In line with PPP theory, when prices of American goods rise
(holding prices of foreign goods constant), the demand for American goods falls and the
dollar tends to depreciate.
✓ Trade Barriers to free trade such as tariffs (taxes on imported goods) and quotas
(restrictions on the quantity of foreign goods that can be imported) can affect the exchange
rate. These increases in trade barriers increase the demand for American steel, and the
dollar tends to appreciate
✓ Preferences for Domestic Versus Foreign Goods If the Japanese develop an appetite for
American goods—say, for Florida oranges and American movies—the increased demand
for American goods (exports) tends to appreciate the dollar.
Increased demand for a country’s exports causes its currency to appreciate in the long run;
conversely, increased demand for imports causes the domestic currency to depreciate.
✓ Productivity When productivity in a country rises, it tends to rise in domestic sectors that
produce traded goods rather than nontraded goods. Higher productivity, therefore, is
associated with a decline in the price of domestically produced traded goods relative to
foreign traded goods. As a result, the demand for traded domestic goods rises, and the
domestic currency tends to appreciate.
In the long run, as a country becomes more productive relative to other countries, its currency
appreciates.1

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 CHAPTER NINE: FINANCIAL SYSTEM REGULATIONS
Introduction
The financial system is among the most heavily regulated sectors of the economy, and banks are
among the most heavily regulated of financial institutions. In this chapter, we develop a framework
to see why regulation of the financial system takes the form it does. Unfortunately, the regulatory
process may not always work very well, as evidenced by the recent 2007–2009 and other financial
crises, not only in the United States but in many countries throughout the world. Here we also use
our analysis of financial regulation to explain the worldwide crises in banking and to consider how
the regulatory system can be reformed to prevent future disasters.
Asymmetric Information and Financial Regulation
Asymmetric information is the fact that different parties in a financial contract do not have the
same information—leads to adverse selection and moral hazard problems that have an important
impact on our financial system.
There are nine basic categories of financial regulation:
❖ the government safety net,
❖ restrictions on asset holdings,
❖ capital requirements,
❖ prompt corrective action,
❖ chartering and examination,
❖ assessment of risk management,
❖ disclosure requirements,
❖ consumer protection, and
❖ Restrictions on competition.

Government Safety Net

Financial intermediaries, like banks, are particularly well suited to solving adverse selection and
moral hazard problems because they make private loans that help avoid the free-rider problem.
However, this solution to the free-rider problem creates another asymmetric information problem,
because depositors lack information about the quality of these private loans. This asymmetric

60
information problem leads to several reasons why the financial system might not function well

Bank Panics and the Need for Deposit Insurance Before the FDIC started operations in 1934a
bank failure (in which a bank is unable to meet its obligations to pay its depositors and other
creditors and so must go out of business) meant that depositors would have to wait to get their
deposit funds until the bank was liquidated (until its assets had been turned into cash); at that time,
they would be paid only a fraction of the value of their deposits
Indeed, bank panics were a fact of American life in the nineteenth and early twentieth centuries,
with major ones occurring every 20 years or so in 1819, 1837, 1857,
1873, 1884, 1893, 1907, and 1930–1933. Bank failures were a serious problem even during the
boom years of the 1920s, when the number of bank failures averaged around 600 per year

A government safety net for depositors can short-circuit runs on banks and bank panics, and by
providing protection for the depositor, it can overcome reluctance to put funds in the banking
system. One form of the safety net is deposit insurance, a guarantee such as that provided by the
Federal Deposit Insurance Corporation (FDIC) in the United States in which depositors are paid
off in full on the first $250,000 they have deposited in a bank if the bank fails

The FDIC uses two primary methods to handle a failed bank. In the first, called the payoff method,
the FDIC allows the bank to fail and pays off deposits up to the
$250,000 insurance limit (with funds acquired from the insurance premiums paid by the banks
who have bought FDIC insurance). After the bank has been liquidated, the FDIC lines up with
other creditors of the bank and is paid its share of the proceeds from the liquidated assets

In the second method, called the purchase and assumption method, the FDIC reorganizes the bank,
typically by finding a willing merger partner who assumes (takes over) all of the failed bank’s
liabilities so that no depositor or other creditor loses a penny.
The FDIC often sweetens the pot for the merger partner
▪ by providing it with subsidized loans or
▪ by buying some of the failed bank’s weaker loans

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Other Forms of the Government Safety Net

In other countries, governments have often stood ready to provide support to domestic banks facing
runs even in the absence of explicit deposit insurance.

Restrictions on Asset Holdings

The moral hazard associated with a government safety net encourages too much risk taking on the
part of financial institutions. Bank regulations that restrict asset holdings are directed at
minimizing this moral hazard
Even in the absence of a government safety net, financial institutions still have the incentive to
take on too much risk. Risky assets may provide the financial institution with higher earnings when
they pay off, but if they do not pay off and the institution fails, depositors and creditors are left
holding the bag. If depositors and creditors were able to monitor the bank easily by acquiring
information on its risk-taking activities, they would immediately withdraw their funds if the
institution was taking on too much risk. To prevent such a loss of funds, the institution would be
more likely to reduce its risk-taking activities
Capital Requirements
Government-imposed capital requirements are another way of minimizing moral hazard at
financial institutions. When a financial institution is forced to hold a large amount of equity capital,
the institution has more to lose if it fails and is thus more likely to pursue less risky activities.
Capital requirements for banks and investment banks take two forms. The first type is based on
the leverage ratio, the amount of capital divided by the bank’s total assets. To be classified as well
capitalized, a bank’s leverage ratio must exceed 5%; a lower leverage ratio, especially one below
3%, triggers increased regulatory restrictions on the bank.
Disclosure Requirements
The free-rider problem described in Chapter 7 indicates that individual depositors and creditors
will not have enough incentive to produce private information about the quality of a financial
institution’s assets. To ensure that there is better information in the marketplace, regulators can
require that financial institutions adhere to certain standard accounting principles and disclose a
wide range of information that helps the market assess the quality of an institution’s portfolio and

62
the amount of its exposure to risk. More public information about the risks incurred by financial
institutions and the quality of their portfolios can better enable stockholders, creditors, and

depositors to evaluate and monitor financial institutions and so act as a deterrent to excessive risk
taking. Disclosure requirements are a key element of financial regulation

Consumer Protection
The existence of asymmetric information also suggests that consumers may not have enough
information to protect themselves fully. Consumer protection regulation has taken several forms.
The Consumer Protection Act of 1969 (more commonly referred to as the Truth in Lending Act)
requires all lenders, not just banks, to provide information to consumers about the cost of
borrowing, including a standardized interest rate (called the annual percentage rate, or APR) and
the total finance charges on the loan
Restrictions on Competition
Increased competition can also increase moral hazard incentives for financial institutions to take
on more risk. Declining profitability as a result of increased competition could tip the incentives
of financial institutions toward assuming greater risk in an effort to maintain former profit levels.
Thus governments in many countries

Prompt Corrective Action

If the amount of a financial institution’s capital falls to low levels, there are two serious problems.
First, the bank is more likely to fail because it has a smaller capital cushion if it suffers loan losses
or other asset write-downs. Second, with less capital, a financial institution has less “skin in the
game” and is therefore more likely to take on excessive risks.
Financial Supervision: Chartering and Examination
Overseeing who operates financial institutions and how they are operated, referred to as financial
supervision or prudential supervision, is an important method for reducing adverse selection and
moral hazard in the financial industry. Because financial institutions can be used by crooks or
overambitious entrepreneurs to engage in highly speculative activities, such undesirable people
would be eager to run a financial institution. Chartering financial institutions is one method for

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preventing this adverse selection problem; through chartering, proposals for new institutions are
screened to prevent undesirable people from controlling them.

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 REFERENCE
Eakins. G.S & Mishkin, S. F. 2012 (Financial Markets and Institutions). Pearson. United States
Kenneth, R S. 2014. Money, banking and international finance. United States
https://corporatefinanceinstitute.com/resources/capital-markets/types-of-security/.
https://www.investopedia.com/terms/f/financialinstrument.asp#:~:text=Financial%20instruments
%20can%
https://www.federalreserve.gov/faqs/money_12855.htm

https://www.rba.gov.au/education/resources/explainers/causes-of-
inflation.html#:~:text=Inflation%20is%20an%20increase%20in,%3A%20Inflation%20and%20its
%20Measurement).

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